Why your clients should consider selling their business to their key employee and how to make that transaction smoother.

January 9, 2012by Heidi Bolger, CPA, ABV

Do you have clients who are thinking about closing their businesses and are looking for succession planning advice and how to find the right buyer? Without them realizing it, your clients may have the perfect buyer-candidate right under their noses.

Key employees are very knowledgeable about what it takes to operate certain aspects of the business successfully and can be high potential entrepreneurs-in-waiting. Your clients may have been working shoulder to shoulder with them for many years. As their CPA adviser, you have probably heard how talented they have been in handling specific facets of your clients’ operations. So why not consider these key employees as potential buyers?

Initial Questions to Consider

There are several important questions your clients should address before initiating discussions with key employees:

How much (total and up front) do key employees want for the business?

What can the business cash flow support in terms of payments and still provide the key employee(s) buyers a good standard of living?

When does the owner(s) want to exit or scale back?

What role does your client want or not want in the business post-sale?

How should they handle any business real estate? For example, does it make sense for your client to remain being a landlord for some period of time?

What new information will have to be shared with key employees to allow them to assess the opportunity?

What’s Plan B if key employees are not interested?

It is necessary to clarify, in writing, what role your client wants you to play as their adviser and what role other professionals may take as this process evolves.

Broaching the Topic With Key Employees

It is recommended that business owners avoid committing to selling their business to any new employee. The risk of committing to a sale before working together for several years is that your client doesn’t really know and understand what the employee can bring to the table. Your client should also avoid making a commitment far in advance of when they plan to exit their business. While your client may want to use the future sale as a way of retaining and motivating very talented members of his or her team, this plan can backfire if your client hangs around too long thereby frustrating their chosen successor(s).

Have your client initiate discussion with key employee(s) — provided some transactions have been recognized and trickled out of shares several years — in an informal way within a year or two of an envisioned ownership shift to employees. Having breakfast, lunch or dinner together can create a friendly setting for the owners to share why they are considering a sale to key employees. Your client should also clarify that other options are possible if a workable agreement can’t be reached. This is the time to ask the team member if they are interested in exploring this option. If there is more than one key employee being considered, this dialogue should be completed one-on-one so a frank discussion can take place regarding how the team member views shared ownership with another team member. The ultimate responsibility of what percentage of ownership gets offered when and to whom rests solely on your client’s shoulders. Once your client has a clear indication that there is interest in pursuing a purchase, it’s time to get ready for the next phase.

How to Prepare for the Next Step

As in any sale transaction, having the key employee(s) sign a non-disclosure agreement is a good place to start. Having a non-compete agreement in place is often also very desirable. At that point, your client will ideally draw on your expertise to structure some scenarios that will work well for both the seller and buyer. These scenarios, based on the parameters your client outlined in your initial work with them, are designed to assess the financial impact the change in ownership will have on the business, including compensation, benefits, perquisites and real estate related expenses. It will also allow your client to see whether their proposed parameters provide adequate cash flow for the down payment as well as the monthly payments that will fund the buy-out and, at the same time, provide a reasonably attractive compensation package and upside for the buyer(s). Once you and your client are comfortable with the scenarios, the process of sharing information and negotiating the specific details of the transaction can get underway.

Pros and Cons of Selling to Key Employees

Some of the good reasons your client should consider selling to key employees include:

Key employees’ abilities have been tested and proven Their integrity and ethics are well known;

Customers already know these individuals and in many cases have quality, long-term relationships;

No outside search process or business broker is required (saving administrative expenses);

Key employee ownership may provide the seller a greater opportunity to stay involved in an acceptable role post-sale (if desired); and

They gain the gratification and gratitude that comes from rewarding key employees the privilege of ownership.

On the other hand, some of the potentially bad reasons or outcomes from a sale to key employees include:

Dealing with unsophisticated buyer(s) may require a lot of hand-holding … increasing the risk of irreparable damage to the relationship should the deal fall through;

Selling to key employees may or may not optimize your client’s selling price vs. the price a sophisticated, synergistic buyer who is already operating in their sector can pay;

Outside buyers may be more seasoned in running and growing your client’s business in the short run;

Negotiating with people you know extremely well and care deeply about can be very challenging;

Offending other employees who don’t get offered the opportunity to purchase the business can create conflict;

Having a key employee step into an owner role can disrupt the chemistry of your client’s team; and

Key employees often lack personal resources required to purchase the business resulting in necessitating the seller to finance the transaction thereby burdening him with continued risk of the business’ success to fund the buyout;

It can be challenging to sell to key employees in a tax-efficient manner

Conclusion

Handing down a business to key employees can get ugly. Having this happen between people who have worked hard together on growing and operating a successful enterprise makes the sting more intense and perhaps more emotional than it tends to be with a seller and buyer who don’t have the same kind of relationship. In an upcoming issue I will divulge tips on what to look for in successor leaders. These important characteristics can keep your client’s succession transaction out of the ugly zone.